Defence & Aerospace Supplier Guidance:

European Aerospace and Defence Mergers and Acquisitions

Publication date: 2007

Deal activity recovering to previous highs
Transatlantic money flows set to resume
Outsourcing by platform primes
Smart tier 2/3 suppliers using M&A to gain scale and scope
Reacquisition of key technologies
Private Equity is actively participating
The future

Deal activity recovering to previous highs

The disclosed value of deals in the Aerospace and Defence (A&D) sector exceeded $33bn in 2006. While not yet up to the previous high of 2000, when over $50bn was invested, this is comfortably above any of the previous five years.

This implies that the industry has finally shaken off the uncertainty and volatility caused by 9/11, Middle East conflict and sluggish economies.

On the civil side, airlines are now looking to cater for continuing growth in global travel and catch up with long postponed fleet upgrade programmes. Growth is now supported across all sectors and geographies, with Asian, Middle East and low cost carriers seeing particular growth.

On the defence side, contractors have benefited from several years of steadily increasing budgets in the United States and Europe. We are currently in a period of high activity: several major programmes are ramping up production, and military commitments overseas are supporting demand for spares and services. In addition, the changing perception of threats and conflicts are leading to a refocusing of spend towards land capabilities, homeland defence and Command, Control, Communications, Computing, Information, Surveillance and Reconnaissance (C4ISR), providing strong growth for players with capabilities in these areas.

There is also a push in Europe for further consolidation in some sectors of the defence industry (principally land and sea). This has to date been deferred by national independence issues, but limiting programme costs is becoming more critical, as the trend continues towards fewer, higher value programmes. And governments are also realising that contractors need scale to be able to compete on the global stage.

We conclude that the A&D industry, once again, has the confidence to make the large-scale and long-term investments implied by Mergers & Acquisitions (M&A). It also has some lost time to catch up, given that many corporate aquirers had postponed M&A-based strategies since 2001 to concentrate on adjusting capacity to meet falling demand and by focusing on internal efficiency.

Average industry operating profit margin turned the corner in 2005, and when all the results are in we expect 2006 to show a significant further improvement – 8 of the top 10 suppliers have posted improved margins in 2006.

Greater confidence is also reflected in the larger average deal size we are now seeing – from a low of $99m in 2003, the average deal in 2006 was approaching three times larger at $267m.

These activity levels have driven acquisition multiples higher, which were higher in 2006 than in any year since 2000. Competition is doubly fierce given that for the first time in recent years both corporate buyers and financial acquirers have the money and appetite to compete for targets in this sector.

Transatlantic money flows set to resume

Much has been written about the acquisition money flowing from Europe into North America, giving European corporates access to the US market. European acquirers spent a total of $5.6bn on North American targets over the last two years, more than double the amount of money coming the other way.

Given that US defence procurement spend accounts for more than 50% of the global total, has been growing at 8% p.a. since 2001, and offers a generally favourable contracting environment, this is not surprising. The Buy America Act, which mandates the preference for domestically produced goods in US government procurement, provides a further impetus for acquiring local assets.

BAE Systems’ $3.5bn acquisition of United Defence Industries in 2005 is the largest case in point, securing access to lucrative support and upgrade work on the Bradley platform as well as positioning for next generation platforms. But EADS, GKN, Cobham and Rolls Royce are further examples of a long list of Europeans buying into the US.

2006 was a pause for breath in this respect, with no major transatlantic deals announced, but the signs are that 2007 will see a resumption of the trend, with Meggitt‘s recently announced $1.8bn acquisition of K&F Industries the latest example.

The challenge for European buyers has been justifying acquisitions at frequently dilutive multiples given the higher ratings afforded to US businesses in this sector. Many acquirers have thought this a risk worth taking given the strategic importance of the US market.

What is also beginning to emerge, however, is the intent of US corporates to seek acquisitions in Europe, and in the UK in particular. US defence spending growth is slowing, so future growth is likely to be harder to come by for the large US contractors. Also, there is strong evidence that the current operational tempo of US overseas deployments may reduce Research, Design, Technology and Evaluation (RDT&E) and postpone platform spending.

The UK is the second largest Western defence market and is also one of the most open to overseas suppliers; the UK Government’s Defence Industrial Strategy (DIS) has made it clear that an industrial presence in the UK is more important than nationality of ownership. So the UK tends to be top of the list of US suppliers seeking to diversify overseas.

Many US primes are therefore believed to be looking for acquisition opportunities in the UK. The first such major deal was GE’s recent $4.8bn (£2.4bn) acquisition of the aerospace division of Smiths Group. Most of the remaining UK listed A&D midcaps have been publicly mooted as potential targets; privately-owned businesses and non-core divisions of larger groups are also likely to come under scrutiny.

Another feature of current M&A activity is the presence of Middle-Eastern investors. Doncasters and SR Technics are recent examples of competitive auction processes won by Middle-Eastern investors seeking to build capabilities and infrastructure in the A&D sector. Dubai in particular, through the Dubai Aerospace Enterprise entity, is seeking to create a $15bn global aerospace portfolio to take advantage of industry growth, to build indigenous capabilities and to leverage Dubai’s geographical position between Asia and both Europe and North America.

Outsourcing by platform primes

In common with several other large-scale manufacturing industries, prime contractors have been considering which activities are core and non-core. As a result, there has been a steady flow of transactions involving divestiture of value- added manufacturing facilities that the primes no longer consider core to their focus on design and assembly of aircraft platforms.

Boeing, for example, has divested nine manufacturing facilities in the last six years – outsourcing aerostructures, electronics, machined components, and wiring operations. BAE and Raytheon have also followed suit. More often than not, these assets have been sold with a long term sole-source contract to provide good visibility and security of revenue. This has fired the interest of financial buyers due to the resulting ability of these businesses to support significant debt finance.

Outsourcing is likely to be an increasing feature at many levels in the supply chain in the future. Boeing’s new 787 ‘Dreamliner’, due for entry into service in 2008, is setting the trend in that the vast majority of the structure of the plane is being outsourced to major sub-assembly providers (Find out more: Supply managers move to mission critical). This radical approach is also helping Boeing generate offsets in countries likely to be large buyers (in particular Japan), but is nonetheless supporting its drive towards being a ‘system of systems’ integrator rather than a vertically integrated manufacturer.

The 787 supply chain is likely to set the tone for the future, in particular given that Boeing’s next generation single-aisle aircraft (the replacement for the ubiquitous 737), is expected to be launched within the next five years and will draw on much of the 787’s technology and supply chain principles.

Airbus itself is perceived to be further behind Boeing in its supply chain restructuring. The complicated industrial structure and political considerations in each of its home nations have, until recently, prevented it from taking the tough decisions on ‘make or buy’ that Boeing has already acted upon.

Airbus is now putting into action its ‘Power8’ restructuring plan, designed to enable Airbus to compete effectively without the underlying support of a strong dollar. As part of this programme, Airbus has announced that several of its manufacturing plants are earmarked for outright disposal, and several further plants for transferral into joint venture agreements with industrial partners. We see this as a welcome part of bringing Airbus back to operational health, and would expect there to be significant interest in the plants from a similar set of players to those that have already taken advantage of the outsourcing by Boeing and BAE.

Smart tier 2/3 suppliers using M&A to gain scale and scope

Outsourcing and supplier rationalisation means that there are significant opportunities for the best suppliers to gain market share with specific technologies. This is particularly true in the lower tiers of the supply chain (i.e. component and subsystem suppliers), as these segments of the market are still very fragmented in comparison to the primes or their Tier 1 suppliers.

Suppliers that can offer a broad range of products, supply chain management capabilities, and a willingness to undertake risk sharing contracts, both financial and technical, will make the grade as ‘strategic’ suppliers. Those that can’t will find organic growth through new contract wins more difficult and will risk being disintermediated by more forward-thinking suppliers.

A critical driver of all three of these capabilities is scale. In announcing the divestiture of Smiths Group’s Aerospace division in January 2007, Chief Executive Keith Butler-Wheelhouse stated:

The structure of the industry is changing – in particular its increased capital requirements and the growing importance of supplier scale, especially as the next generation of large programmes kicks in.

Not surprisingly, a large element of recent M&A activity has therefore been driven by suppliers seeking to gain this scale. These deals do, however, tend to be smaller.

Reacquisition of key technologies

Aerospace & Defence is a global high technology industry. The complexity of modern platforms is such that no one organisation, nor indeed even one nation, can develop a new platform without access to ‘best in class’ technologies from the global supply base. These proprietary technologies take many forms, for example new lightweight materials, improved electronic/IT systems, integrated C4ISR architectures, sensor suites, and simulation technologies, covering the civil, military, and homeland security environments. Companies that have proprietary technology have consistently represented attractive targets for acquirers seeking to access pockets of growth and cross selling opportunities.

In addition, our analysis shows that successful lower-tier suppliers can be significantly more profitable than the primes, due in part to their ability to capture the value of specific proprietary technology and, in some cases, the associated aftermarket.

These two factors mean that even Primes and Tier 1 suppliers are seeking out and acquiring targets with specific technologies, even if this goes against the notion of primes as ‘system of systems’ integrators noted above.

The acquisition profiles of these businesses therefore tend to show a small number of major strategic moves, together with a larger number of (often very small) technology businesses. Acquirers with this profile include:

BAE Systems, which followed up its $3.8bn acquisition of United Defense Industries in 2005 with a $9m acquisition of a manufacturer of advanced optical systems (National Sensor Systems) in 2006.
General Dynamics, which acquired five small technology-driven businesses in the US during 2005 and 2006, as well as spending a combined $2.3bn on Anteon and SNC.
Thales, which has undertaken five small acquisitions over the last two years, while making major strategic investments in DCN and Alcatel.

Private Equity is actively participating

The demand volatility shown in the industry following 2001 frightened many private equity investors away from the sector. Such volatility has a magnified impact on highly leveraged businesses, and given that the downturn was due in part to unforeseeable events, several private equity houses experienced disadvantageous results.

To show that fortune favours the brave, those that did ‘bottom fish’ during 2002 and 2003 have made excellent returns now that both market demand and acquisition multiples have increased. Example deals include:

MTU
Avio SpA
Racal Acoustics
e2v Technologies
SR Technics and FLS
K&F Industries

The sector is now attracting record levels of private equity investment, across a wide range of deal sizes. Four of the top five majority stake transactions in 2006 involved private equity as either buyer or seller. Private equity participation does fall a little in smaller deal sizes – 10 of the top 20 and 17 of the top 50 deals involved private equity investors.

Private equity has been attracted by the restructuring and globalisation in the supply chain, and has provided much needed liquidity in the market as larger players divest assets and the supply chain consolidates.

In addition, the industry provides a sufficiently broad range of business models to attract investors that don’t feel comfortable with the inherent volatility of the commercial OE build segment. The Military OE segment, spares and services such as maintenance, repair, and overhaul (MRO, itself a $45bn industry), can all offer more stable and predictable profit streams, irrespective of the civil aerospace build cycle.

Finally, there are opportunities for good suppliers to access above-market growth through the supplier rationalisation or outsourcing discussed above. Providing investors can get comfortable that they are backing a winner (more often than not a question of management), the rewards are substantial.

The exit environment should remain favourable; corporate M&A was hamstrung for four years following 2001 but as demand remains strong over next few years and these structural changes work through we expect corporate M&A to continue regaining momentum.

The future

We expect that the drivers we have outlined on the preceding pages will sustain high levels of M&A in the sector over at least the next two years, barring any unforeseen ‘extraneous’ events. It is only relatively recently that corporate investors have returned to the market and they have to make up on lost time to position themselves for the future.

We expect to see US corporates on the hunt for European (and particularly UK) assets, continuing tier 2/3 consolidation, and asset-shuffling between major players as they realise that focused scale is important and make their choices about where to concentrate their efforts.

The UK shipbuilding industry is currently looking to restructure in response to the government’s Defence Industrial Strategy, and we may also see the European land and naval sectors start to consolidate.

And below all this, the search for strong positions in new technologies will go on, providing an ‘undercurrent’ of M&A. Particularly high growth market segments that may see more of this activity include:

Composites
C4ISR
Chemical, Bioligical, Radiological and Nuclear (CBRN) detection and prevention
Unmanned Aerial Vehicle (UAV) platforms and systems.

The five themes we have covered will be played out, to varying degrees, over the course of the next 2 to 3 years. The implications for the global A&D industry will be dramatic, but they will shape the structure of the industry for the next decade to come.

Source: PricewaterhouseCoopers
Publication date: 2007